Making A Down Payment On Lennar

Jul. 16, 2018 9:51 AM ETLennar Corporation (LEN)TOL1 Comment
David Harper, CFA profile picture
David Harper, CFA
400 Followers

Summary

  • Capital intensity, cyclicality and cost (inflation) sensitivity render homebuilders unfriendly to investors, but at least they know the risks.
  • At the moment, macroeconomic threats (in particular higher long-term rates) appear to be outweighed by compelling product supply/demand dynamics, including buyer demographics.
  • Early signals from Lennar's completed CalAtlantic acquisition are decidedly positive. Lennar is now among the two largest homebuilders (along with D.R. Horton), and well-positioned to benefit from economic "downturn avoidance".
  • A compelling alternative (albei thigher risk/reward) is Toll Brothers: a uniquely positioned luxury builder whose affluent buyers pay twice the peers' average sales price (and 22% are all-cash).

I added Lennar (NYSE:LEN) to my portfolio six weeks ago, despite feeling inexpert in the homebuilder group. At the bottom of this article, I disclose the exact status and performance of my equities portfolio (like I did when I sold Kroger (KR) and bought Facebook (FB)). I've recently enjoyed the genuinely fun experience of touring open houses in Southern California and Austin, TX. We looked at homes built by many of the public homebuilders. In these high-growth suburbs (and so-called "surban living areas") planned community developments are popular.

A compelling example in my neck of the woods is Cadence Park, one of several Great Park Neighborhoods in Irvine, CA. When finished, it will be a destination unto itself. A delightfully quirky community park with an outdoor amphitheater, indoor studio, and in-construction K-8 school will anchor miles of nearby trails (highly "walkability" is a key metric).

A full gamut of new homes is offered, in phases, at almost every price point that is possible in the broader city (albeit Irvine is very expensive), from attached townhomes to expensive single-family residences. Here Lennar offers at several price points, along with other builders like KB Home (KBH). Lennar's homes sizzled at the opening, and are selling out quickly.

Among the builders, quality and styles vary noticeably. I won't mention my least favorite, but as a mere window shopper three builders in particular impressed me: Toll Brothers (TOL), Taylor Morrison (TMHC) and Lennar. After further research, I settled on Lennar for an initial position. As a stock, Lennar is not a high-conviction purchase, unlike Instructure (INST) which is a high-conviction holding. I think Lennar's current discount might be a fully logical reflection of its risks, which are numerous when itemized.

For me it boils down to: I am willing to bet that a housing downturn is not coming anytime soon - or at least before Lennar's solid fundamentals are rewarded by a less-discounted price - and Lennar is well-positioned to benefit from economic downturn avoidance. Alternatively, I think Toll Brothers is also a very tempting stock. Last weekend, Barron's argued TOL was undervalued by about the amount of its year-to-date loss, a whopping 23%. I might decide to also add TOL later. If I'm wrong about LEN, I don't think the cost of my education will be too great (LEN is down 15.2% YTD, near the group's average loss).

Cycles, Capital, Factors: Yikes, what is there even to like here?

You could easily argue that this industry should be avoided. Here begins my negative sell. Homebuilders remind me of airlines, in terms of sheer investor undesirability. They are both: capital-intensive, economically cyclical, painfully factor cost-sensitive (e.g., jet fuel, labor, lumber), and highly competitive. Airlines at least engender some brand loyalty with enthusiasts. Homebuilders might not enjoy any brand loyalty: buyers are infrequent, they prioritize location and price.

It appears that investors don't generally credit any of the builders with a meaningful moat. Indeed, the first thing I noticed about the homebuilders is that they are a tight-knit group in terms of price action. You can start to feel as if any purchase in this group is basically the same macroeconomic bet. Below is the 5-year chart of the nine largest homebuilders (i.e., sales above $3.0 billion). Until this year, where the group is largely down -10% to -20%, the standout exception was NVR, Inc. who builds only in the East and Mid-Atlantic. Except for NVR, the builders often move together.

sa-price-chart-version2In terms of daily returns, the pairwise correlations are very high (NVR's relatively lower correlations comport with its outperformance):

len-pairwise-rho

Over any short run, this is a common factor zoo. But I'm not a short-term trader. I cannot improve on Hoya Capital's consistently superior commentary. His (Alex's) five good reasons to be bearish are: Homebuilding is a tough, low-margin business; Construction costs further squeeze margins; housing unaffordability; interest rate sensitive; and tax reform tips scales toward renting. However, among the group, he does rank Lennar first.

But I'm less worried about long-term interest rates and taxes

The bearish issues that I am less concerned with (relative to consensus) are interest rates and taxes. Interest rates are more complicated than complex. The Fed is raising an overnight rate. In theory, long-term nominal mortgage rates are a function primarily of the term structure (future rate expectations, inflation expectations, and term premium) plus spread factors.

Those are the fundamentals. When we teach fixed income to FRM candidates, a recurring theme is how these fundamental factors are so often overwhelmed by market (aka, technical) factors, so that instruments can defy their models by persisting in a tendency to "trade cheap" or "trade rich" relative to their apparent arbitrage value. The key technical factors are supply/demand and liquidity. In the current context, a fundamental narrative is understandably prone to predict higher (or significantly higher) mortgage rates, although inflation is a swing variable.

Here is a technical reality that fascinates me: geopolitical risk outside the U.S. helps flatten our term structure, and in turn, puts a soft lid on mortgage rates. In the perverse logic of capital markets, if you are borrowing long in the US, you might be a horrible person because you may secretly root for bad news on CNN so your mortgage rate drops in reaction to the inevitable flight to quality.

I perceive geopolitical risks will be a persistent backdrop, enabling demand for Treasuries (despite mounting US debt), so I tend to think there will continue to be a soft upper limit on long-term mortgage rates. That said, if I do get proved wrong with this small investment, I have a feeling it will be because I get this interest rate thing wrong.

With respect to taxes, I live in California and we should already be feeling the hurt of the Tax Cuts and Jobs Act (TCJA) which, for us, might better be called Yet Another Brutal Blue State Tax Increase (aka, YABBSTI, which I admit does not roll off the tongue). Where home prices are high, the pain is undeniable. The doubled standard deduction doesn't greatly help deduction itemizers, where the swift kick in California's blue crotch is specifically the $10,000 cap on state and local (SALT, including property tax) deductions.

There is additionally a reduction in the mortgage interest deduction, but this is only a reduction from $1.0 million to a $750,000 cap on the mortgage loan. So many buyers - especially in other states - will not be affected; e.g., if you put 20% down, you can itemize the interest all the same up to a purchase price of $750,000/0.80 = $937,500. Lennar's average sales price in the last quarter was $413,000, up from an average price of $361,000 during fiscal 2017.

I visited several Lennar community developments in Austin's beautiful suburbs, where common price points are $300,000 to $400,000 or so (while Austinites understandably lament their escalating home prices, in general they can still get the same house for 50% or less than it would cost in Southern California). So the overall tax impact is a very mixed bag. To the extent Lennar (or any builder) might be hurt in California, they will be a net beneficiary in Texas where they are prolific (the Austin area alone hosts ~ 60 Lennar communities) not to mention many other strategic geographies.

Similarly, while some buyers are hurt by the tax plan, many individuals are helped, on balance. It makes complete sense to me that Lennar's CEO Rick Beckwitt said on the earnings call, "while many continue to express concerns about the effect of the tax law on housing, it is proving to be a positive to the wallet of our customer base and stimulative to the economy overall, which is good for housing."

Catching-up supply struggles to meet pent-up demand

Maybe the best bullish argument in favor of well-positioned single-family homebuilders is good old fashioned product supply and demand. Here, the timing looks favorable. The supply shortfall looks to persist for the foreseeable future. Below is a 30-year look at housing starts. I think this is a good proxy for total market potential, but I would appreciate any criticism of such a statement. The April 2009 trough saw only 485,000 annualized starts.

May 2018 starts have almost tripled to 1.35 million annualized. This seems to be a complicated, debated variable. I've read commentary suggesting starts wants to revert to their natural average of 1.60 million or more, implying significant shortfall. While I cannot confidently project, I would just say that a naive look at this historical trend suggests to me that it has room to growth further, at a minimum.

fred-version2This still-catching-up supply looks to continue to be met by pent-up demand, if healthy buyer trends (and economic conditions) continue. Buyer demographics look favorable, notably including the "active adults" (protip: say "55 years old or better" not "55 years or older") where Lennar seems very positioned with many compelling communities.

A little bit about Lennar

A favorable catalyst is Lennar's $9.0 billion acquisition of CalAtlantic that closed only this February. The last reported quarter was their first full, combined quarter. The balance sheet has gracefully weathered this transaction: debt-to-equity (book) is about 0.80, which matches MTH, PHM, TOL and TPH (and is less than KBH), and they are already ahead of pace in paying down debt, integration savings and projected cash flows. LEN continues to pay a small $0.16 dividend (about 0.30%). Note: my sources for key quoted financial information (e.g., debt-to-equity) are recent SEC filings, see 10-Q here and see 10-K here.

The acquisition makes Lennar and D.R. Horton the two largest homebuilders, in the neighborhood of $15.0 billion in annual sales. CalAtlantic homes present as a notch higher in quality. CalAtlantic has built some stunning luxury homes here in Southern California, where I perceive almost compete directly with Toll Brothers. Toll brothers is uniquely positioned as a luxury builder, with an average base sales price that is 90% higher than Lennar's. And then TOL's customers further add an hefty average of $152,000 per home in upgrades and customizations, so that Toll's average per-home prices are roughly double everybody else's.

TOL is sui generis among the public peers. Impressively, 22.0% of Toll's buyers pay full cash (source: 10-K Business Trends). If you otherwise like the timing of this beaten-down homebuilder sector, but are concerned about softening buyer demand (which I am not so much), then you might prefer TOL to LEN.

Lennar is not exactly a pure-play. It also operates Eagle Home Mortgage LLC, a subsidiary that originated fully 80% of Lennar's own buyers' mortgage loans in 2017 ($9.0 billion) and Rialto Capital, a real estate investment manager.

They are looking to divest Rialto: "as previously announced in April, we have engaged Wells Fargo Securities and Deutsche Bank Securities to advise us regarding possible strategic alternatives relating to our Rialto investment and asset management platform, and we remain committed to our strategy of reverting to our pure-play core homebuilding platform," Lennar disclosed in the Outlook section of the last 10-Q.

I'll wrap with selected highlights that tilted me in Lennar's favor:

  • The valuation is appealing given its YTD drop. At today's price of $53.78, trailing P/E is about 14.0. Assuming the company's guidance for the second half of the year, the semi-forward P/E is 10.65. The analyst-based forward P/E appears to be only 7.8.
  • For a sense of the growth rate, a good look is backlog growth (to keep it simple, I will exclude CalAtlantic). Lennar grew dollar backlog +24% from $2.9 billion to $3.6 billion, at the end of fiscal 2017. But the cancellation rate is about 15%, a significant drag on backlog. Conservatively, it seems entirely plausible to assume go-forward organic growth of at least 10.0% (i.e., as a conservative lower bound). For the quarter, gross margin exceeded expectations at 21.6%. Aside from interest rates, cost inflation is a major investor concern, so this will be a dearly watched metric. Last year, our administration imposed a ~ 20% tariff on Canadian softwood lumber. The CEO of Meritage Homes (MTH) said that lumber prices are adding $3,000 on average to the cost of each home this year. Of course this could be a problem, but in theory, Lennar's size advantage should help it cope with rising factor costs.
  • Lennar sells an "Everything's Included" approach. Options that are normally itemized additions are bundled into the price. This includes things like smart locks, Amazon Echo connectivity, and energy-efficient features. As a window shopper, this is a very noticeable distinction in the model homes I viewed. Amazon smart devices are prominently marketed. You also get the sense Lennar can actualize some of its digital marketing intentions.
  • Their NextGen "home within a home" targets multi-generational households, has a +35% higher average sales, and grew +21% last year

Update on my portfolio

Below is the status of my equities portfolio. Adding LEN brings me to 21 positions. As a very part-time investor, I am holding too many individual stocks (I've only sold KR) because I simply cannot monitor them effectively. I'll evaluate BAC after its next earnings, as it has fulfilled my original thesis. I am feeling ready to realize this gain, but I'll wait for the next quarter's information.

I bought FB only to realize a tactical +25% gain, believing the privacy scandal would be irrelevant (the senate hearing was even worse than I expected. Clearly, regulators don't even know which questions to ask), despite the fact that I really do not respect their governance. FB is not a company I want to own long term, so I probably want to sell it soon. In Facebook, I violated Buffett's advice: “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.”

Since I bought CVS only ten months ago, two clouds materialized: the Aetna (AET) acquisition, then Amazon's (AMZN) brilliant PillPack acquisition. I am not convinced yet that either changes my motivating idea (the PBM). AMAT is down primarily on tariff concerns, which are no longer imaginary, but I see no reason to panic on tariffs. (But my real AMAT dilemma is that I am simply out of my depth with respect to their true competitive position).

Starbucks (SBUX) is down, but I never had high expectations: For me SBUX is relatively safe quasi-cash holding with an option on China. I wonder if I missed a chance to take profits on VLKAY, but their fundamentals are strong, so I believe it will come back. My belief is that I am better off in the long run to never rush to either buy or sell, including never sell before the quarter based on some idea about the quarter. The purpose of the quarter is to give me an update on the fundamentals. My first rule is, don't be in a hurry. Thank you for reading!

my-portfolio-0712

This article was written by

David Harper, CFA profile picture
400 Followers
I am an EdTech entrepreneur and instructor in advanced risk, finance and data science. I founded and operated (as lead instructor) my financial education company Bionic Turtle (BT) for 15+ years. BT was twice endorsed by Investopedia as the Best (#1) overall exam prep provider (EPP) for the Financial Risk Manager (FRM). BT was acquired by CeriFi in February 2021. My teaching domains include quantitative methods, financial products, financial markets, valuation, risk models, market risk, credit risk, operational risk, regulatory issues (e.g., Basel) and investment risk.I am an experienced R programmer and data scientist. My areas of focus are investing (emphasis in themes: tech, real estate), edtech, risk, applied math, expert finance, data science, and the future of work (FOW). My programming interests include visualization, time series, portfolio analytics and simulation. My data blog is located at https://dh-data.org/ and github is located at https://github.com/bionicturtleI am an active Chartered Financial Analyst (CFA) and Financial Risk Manager (FRM).

Disclosure: I am/we are long LEN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long all of the 21 stocks listed in the final exhibit above: AAPL, AMAT, AYX, BAC, CHGG, CLDR, CVS, DISCK, DOC, FB, GOOGL, HDP, HPQ, INST, INVH, LEN, QTWO, SBUX, SFM, VLKAY and XROLF

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